Bonuses Are Good, But Clawbacks Make Them Better

By order of the Her Majesty, the Queen, Sir Fred Goodwin — aka “Fred the Shred” — suffered an unprecedented clawback. The disgraced former Royal Bank of Scotland CEO was stripped of his knighthood “for services to banking.” Barely four years after Goodwin’s elevation, his bank — Great Britain’s wealthiest — effectively collapsed and was nationalized. “The scale and severity of the impact of his actions as CEO of RBS made this an exceptional case,” the Honors Forfeiture Committee mandarins concluded. Goodwin had brought the honors systems into disrepute; his award was thus annulled.

The controversial action — Britain’s Institute of Directors warned of “anti-business hysteria” while Prime Minister David Cameron declared it “the right decision” — invites exactly the sort of “best practice” debate serious business leaders should have about honest compensation and perverse incentives. People respond to incentives. Poorly designed and/or cavalierly monitored incentives frequently lead to horrendous outcomes.

The fundamental asymmetry, of course, is the presence of bonuses and an absence of clawbacks. That is, individuals and teams may receive impressively large and ostensibly “performance-based” bonuses if they hit their numbers. However, they typically need not worry about forfeiture if, upon review, those numbers require restatement, revision or repair. Misleadingly-gotten gains are not “clawed back.” Or, colloquially, heads, they win; tails, they don’t lose.

This status quo is unacceptable: any organization that invests more time and thought into designing performance bonuses than considering clawbacks is guilty of bad behavioral economics and even worse management. Clawbacks shouldn’t be punishment for flawed decisions or bad luck; they’re deterrents and insurance policies for organizations that fear that talented individuals may take inappropriate and unsustainable shortcuts to get the bonus. Clawbacks are an essential technique for balancing long-term business health against short-term bonus wealth.

Otherwise institutionalized imbalances in compensation encourage too many people to “game the system.” Traders are notorious for developing schemes that sync with how their compensation and bonuses will be paid out. Their defenders argue that consistent losers will, of course, get fired — so what’s the long-term point of clawbacks? But that ignores the (obvious) behavioral reality that traders who know that their greatest risk is losing their job — instead of their money — might be prone to making even larger bets to win comparably larger bonuses. The upside potential overwhelms the downside exposure. That’s a proven recipe for disaster.

For example, I’ve seen software development teams get a cash bonus and stock options for delivering their code early and under budget. But what became disturbingly clear less than six months later is that the team withheld useful information it learned in testing that would have made the software much more robust and scalable because the revision would have blown the bonus deadline by a month. Developing better software would have paid less. Similarly, there’s been no shortage of savvy salespeople I’ve observed who close large, bonus-winning contracts that have artfully phrased “service level agreement” clauses that end up annihilating margins. A few of the larger contracts even led to “rev rec” (revenue recognition) restatements that triggered audit committee reviews. Yes, the sales team was (ultimately) fired. Yes, they kept their bonus money. Yes, the sales people who played by the rules got nothing.

But clawbacks represent one of those rare mechanisms which represent a convergence between populist concerns and better incenting high performance outcomes. The public wants assurances that executive compensation is not determined by crony capitalists; investors seek greater confidence that incentive schemes don’t lead to expensively perverse outcomes; and play-by-the-rules employees who invest more effort in creating value than gaming the bonus pool appreciate efforts that don’t reward colleagues and bosses who are too clever by half.

Healthy conversations around clawbacks are as important to risk-management and employee morale as well-designed incentive-based compensation programs and a generous bonus pool. I’d argue there’s no such thing as well-designed incentive compensation programs that don’t have a carefully calibrated clawback component. Emphasizing bonuses at the expense of clawbacks is bad for everyone.

Have you had a constructive clawback conversation with your pay-for-performance people?

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